Does performance-based compensation actually improve a CEO’s performance?

March 17, 2023, 3:33 PM UTC
Shannon Fagan—Getty Images

Shareholder-CEO relationships aren’t always based on good faith, where shareholders simply trust a CEO will fulfill their fiduciary duties to the best of their ability. Instead, corporate boards often deploy pay-for-performance models, withholding part of a CEO’s compensation to bridge the gap between shareholders and the C-suite.

“One reason we see pay-for-performance models favored is they are generally viewed more favorably by the shareholders, to the extent that the achievement of financial performance is linked to value creation for the shareholders,” says Noah Kaplan, a managing director at corporate strategy advisors FW Cook.

According to FW Cook, 88% of the 250 largest S&P 500 firms utilize performance-based compensation for some portion of executive pay, where total compensation is most often tied to revenue or profit goals and paid out in equity. However, executive compensation is not always linked so directly to shareholder returns, which tend to materialize over long-term time horizons.

If a company is pursuing short-term goals, such as a dramatic business transformation, then performance-based compensation models tend to pay out in cash, rather than equity, to reward short-term accomplishments.

But, despite the ubiquity of pay-for-performance structures in U.S. corporations, it’s unclear whether the conditional compensation model is actually effective at driving performance. Kaplan notes that because so many companies deploy pay-for-performance systems, and do so consistently, there are almost no control cases to measure their success against.

Performance-based compensation can even be a little unfair to executives—for example, when black swan events, like the COVID-19 pandemic, disrupt business operations beyond the CEO’s control. Yet according to FW Cook’s research, the number of top S&P 500 companies implementing pay-for-performance models has actually risen since before the pandemic.

Just last month Dominion Energy, the Virginia-based power company, announced it was making the non-salary part of its CEO’s compensation 100% performance-based, to “align CEO compensation with long-term share price performance, consistent with the objectives of the current strategic business review.”

Dominion Energy’s share price is down roughly 25% from a year ago and has fallen faster than the average for the S&P 500 this year. Now that Dominion Energy has aligned its CEO’s pay with shareholder returns, without changing CEOs, the company might serve as a fair test for whether these compensation models work. 

But Jon Burg, managing partner at corporate advisor Infinite Equity, is skeptical that pay-for-performance models actually do much to drive performance. He says they’re more useful as a tool for setting goals.

“Agreeing on a performance-based compensation model helps establish what the board expects of the CEO,” Burg says. “But once it’s agreed upon, I don’t know that someone’s actual performance [changes]. It probably comes down more to their own capabilities.”

Since CEOs will typically have a salary that isn’t conditioned on performance, Burg says, executives are more likely to view the conditional part of their compensation as a bonus rather than a necessity.

So do pay-for-performance models actually work to ensure CEOs deliver on targets? Perhaps not as much as simply hiring a manager you can trust.

Eamon Barrett


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